New neoclassical synthesis

New neoclassical synthesis

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New neoclassical synthesis or new synthesis is the fusion of the major, modern macroeconomic schools of thought, new classical
New classical macroeconomics
New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics...

 and new Keynesian
New Keynesian economics
New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of New Classical macroeconomics.Two main assumptions define the New...

, into a consensus on the best way to explain short-run fluctuations in the economy.Mankiw (2006), 38. This new synthesis is analogous to the neoclassical synthesis
Neoclassical synthesis
Neoclassical synthesis is a postwar academic movement in economics that attempts to absorb the macroeconomic thought of John Maynard Keynes into the thought of neoclassical economics...

 that combined neoclassical economics
Neoclassical economics
Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits...

 with Keynesian macroeconomics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

. The new synthesis provides the theoretical foundation for much of contemporary mainstream economics. It is an important part of the theoretical foundation for the work done by the Federal Reserve and many other central banks.

Prior to the synthesis macroeconomics was split between new Keynesian work on market imperfections demonstrated with small models and new classical work on real business cycle theory
Real business cycle theory
Real business cycle theory are a class of macroeconomic models in which business cycle fluctuations to a large extent can be accounted for by real shocks. Unlike other leading theories of the business cycle, RBC theory sees recessions and periods of economic growth as the efficient response to...

 that used fully specified general equilibrium
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...

 models and used changes in technology to explain fluctuations in economic output. The new synthesis has taken elements from both schools. New classical economics contributed the methodology behind real business cycle theory and new Keynesian economics contributed nominal rigidities (slow moving and periodic, rather than continuous, price changes also called sticky prices
Sticky (economics)
Sticky, in the social sciences and particularly economics, describes a situation in which a variable is resistant to change. Sticky prices are an important part of macroeconomic theory since they may be used to explain why markets might not reach equilibrium right away. Nominal wages are often said...

).

Four elements


Goodfriend and King (1997) proposed a list of four elements that are central to the new synthesis: intertemporal optimization, rational expectations, imperfect competition, and costly price adjustment (menu costs).Snowdon and Vane, 411. Goodfriend and King also find that the consensus models produce certain policy implications. In contradiction with some new classical thought, monetary policy can impact real output in the short-run, but there is no long-run trade-off: Money is not neutral
Neutrality of money
Neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages and exchange rates, with no effect on real variables, like employment, real GDP, and real consumption....

 in the short-run but it is in the long-run. Inflation has negative welfare effects. It is important for central banks to maintain credibility through rules based policy like inflation targeting.

Five principles


More recently, Michael Woodford
Michael Woodford
Michael Woodford is the name of:*Michael Woodford, Jr., American ice hockey player*Michael Woodford , American macroeconomist*Michael Woodford , former CEO of Olympus Corporation...

 attempted to describe the new synthesis with five elements. First, he stated that there is now agreement on intertemporal general equilibrium
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...

 foundations. These allow both short-run and long-run impacts of changes in the economy to be examined in a single framework and microeconomic and macroeconomic concerns are no longer separated. This element of the synthesis is partly a victory for the new classicals, but it also includes the Keynesian desire for modeling short-run aggregate dynamics. Second, the modern synthesis recognizes the importance of using observed data, but economists now focus on models built out of theory instead of looking at more generic correlations. Third, the new synthesis addresses the Lucas critique
Lucas critique
The Lucas critique, named for Robert Lucas′ work on macroeconomic policymaking, argues that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.The basic idea...

 and uses rational expectations. However, based on sticky prices and other rigidities, the synthesis does not embrace the complete neutrality of money proposed by earlier new classical economists. Fourth, the new synthesis accepts that shocks of varying types can cause economic output to fluctuate. This view goes beyond the monetarist view that monetary variables cause fluctuations and the Keynesian view that supply is stable while demand fluctuate. Older Keynesian models measured output gap
Output gap
The GDP gap or the output gap is the difference between potential GDP and actual GDP or actual output. The calculation for the output gap is Y*–Y where Y* is actual output and Y is potential output...

s as the difference between measured output and an ever growing trend of output capacity
Potential output
In economics, potential output refers to the highest level of real Gross Domestic Product output that can be sustained over the long term. The existence of a limit is due to natural and institutional constraints...

. Real business cycle theory did not consider the possibility of gaps and used changes in efficient output, caused by shocks to the economy, to explain fluctuations in output. Keynesians rejected this theory and argued that changes in efficient output were not large enough to explain wider swings in the economy. The new synthesis combines elements from both schools on this issue. In the new synthesis, output gaps exist, but they are the difference between actual output and efficient output. The use of efficient output recognizes that potential output does not grow continuously, but can move upward or downward in response to shocks. Finally, it is accepted that central banks can control inflation through the use of monetary policy. This is partly a victory for monetarists, but new synthesis models also include an updated version of the Philips curve that draws from Keynesianism.

See also

  • History of macroeconomic thought
  • Mainstream economics
    Mainstream economics
    Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...

  • Neoclassical synthesis
    Neoclassical synthesis
    Neoclassical synthesis is a postwar academic movement in economics that attempts to absorb the macroeconomic thought of John Maynard Keynes into the thought of neoclassical economics...

  • New classical macroeconomics
    New classical macroeconomics
    New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics...

  • Neo-Keynesian economics
    Neo-Keynesian Economics
    Neo-Keynesian economics is a school of macroeconomic thought that was developed in the post-war period from the writings of John Maynard Keynes. A group of economists , attempted to interpret and formalize Keynes' writings, and to synthesize it with the neo-classical models of economics...